March 18, 2010

Selling Investors Short The SEC refutes its own short-sale ban.

Another day, another party-line 3-2 vote at the Securities and Exchange Commission on another transparently political initiative from Chairman Mary Schapiro. What was new about Wednesday’s vote to approve new limits on short-selling was that not even Ms. Schapiro claimed there was any evidence that short-selling is harming investors—or that her new rule will help investors.

Short-sellers borrow stock and sell it with the expectation that it will fall in price. The shorts then buy back the shares at the lower price, pocket the difference and return the shares to the original owner. Sometimes, struggling companies blame short-sellers for driving down their share prices because that’s easier than explaining what management has done to make investors flee the stock.

In fact, short-sellers make for a more efficient market by allowing all points of view to be expressed in a company’s stock price. The SEC came to this conclusion several years ago when it abandoned the so-called uptick rule that had prevented a short-sale unless the last movement in the stock price had been up. The idea was that the rule would serve as a brake on market panics, preventing sharp declines in stock prices, while also preventing short-sellers from manipulating the market.

After years of study and a long pilot test, the SEC staff found no evidence that the uptick rule did any of these things. Studying the 2008 crisis, when the SEC enacted outright bans on short-selling many financial stocks, the SEC staff still hasn’t found evidence that such limits benefit investors.

But two Democratic commissioners joined Ms. Schapiro to create new limits anyway. The new uptick rule says that once a stock has declined 10% or more in a trading day, short-sales must occur above the highest current public bid for the shares. The rule will be in place for the rest of the trading day plus the next day.

Without empirical data that America’s markets will be better off as a result, the SEC chairman said Wednesday that since there were so many “concerns” expressed about short-selling, and so many “calls” for new restrictions, creating such restrictions will “preserve investor confidence.” Ms. Schapiro’s argument is essentially that, even though the SEC staff has studied the issue exhaustively and found bupkus, some investors think it’s a problem and therefore they will feel good when they see the SEC regulating it.

As dissenting Commissioner Troy Paredes noted, “The self-fulfilling logic would seem to be that merely by regulating, the Commission can claim to shore up investor confidence, thus justifying its decision to regulate.” One hopes for better from a professional and independent agency.

But what if other investors realize that limits on short-selling impede price discovery and reduce liquidity? Won’t these investors lose confidence in U.S. markets? “Price discovery matters because investors would be less willing to invest if the contrarian views of short sellers were not fully incorporated into securities prices. Furthermore, when price discovery is compromised, we run the risk that our securities markets allocate capital inefficiently,” said Mr. Paredes.

Often, when a controversial rule splits the commission, opponents make their case by citing outside research that the SEC staff may not have fully considered. But all of the data knocking down the premise of this new rule is included in the SEC’s own rule-making release. In a bizarre scene, Mr. Paredes and fellow Republican Kathleen Casey simply quoted from the findings within the Schapiro rule to explain their opposition to it.

Said Mr. Paredes, “The adopting release itself states: ‘[C]oncurrent with the subprime mortgage crises and credit crisis in 2007, U.S. markets experienced increased volatility and steep price declines, particularly in the stocks of certain financial issuers. We are not aware, however, of any empirical evidence that the elimination of short sale price test restrictions contributed to the increased volatility in the U.S. markets.’ It is worth acknowledging a study by SEC economists, the findings of which indicate that selling pressure in September 2008 before the short sale ban went into effect, an especially tumultuous time for the markets, primarily came from ‘long sellers,’ as compared to short sellers, and that short sellers tended to be contrarian during this period. It also is worth observing that financial sector stocks continued to fall during the September 2008 short sale ban, a more restrictive constraint on short selling than the alternative uptick rule the Commission is adopting.”

In other words, stocks tend to fall when investors decide they are worth less, not because of some shadowy machinations by short sellers.

But what the heck, the SEC guesses its new rules will only cost $1 billion in transition costs and then another billion a year to comply. Just what the financial industry needs—another costly political directive that has nothing to do with preventing the next financial crisis.